Libya’s credit crunch

It takes sifting through very little economic data on Libya to realize that the country’s most underutilized and valuable existing resource isn’t underground – oil reserves – but very visibly above ground: the banks.

Specifically, 15 commercial banks and four specialized credit institutions. Despite a series of partial privatizations in 2007, the government continues to own majority or total stakes in these banks. And these Libyan banks are very, very rich.

Data collected by the International Monetary Fund (IMF) shows that the assets held by Libya’s commercial banks grew from LYD 14.5bn to 65.4bn between 2003 and 2010 – an over 350% increase. To put the latest asset figure into perspective: Libya’s entire annual gross domestic product (the totality of economic activity in the country, predominantly oil) is just above LYD 65bn as well.

Bank assets should – at least in theory – be the value of the loans banks give out to their customers, which in the case of commercial banks are businesses. So are these LYD 65.4bn indeed the value of loans these banks have given out to private enterprises?

Very little – in fact only 13.5% (in 2010) – of bank assets were loans to the private sector. The figure in 1990 was 40%. In Libyan Dinars, that translates to a mere 1.4bn in private sector loans in 1990 and an even more sheepish-looking 8.8bn in 2010 (sheepish, given the demographic growth, lifting of the embargo and purported move towards economic liberalization over that period).

At such low levels of private sector lending, Libyan businesses are facing a veritable credit crunch. So what are these assets – or more importantly where is the money – if it’s not being lent out?

A shallow financial sector

Essentially, the money is sitting idly at the Central Bank of Libya in a financial system the IMF terms “rudimentary and shallow”. In 2010, LYD 43.9bn – or 67.2% of total bank assets – were held in the form of deposits at the CBL. The current figure is estimated at just above LYD 40bn for 2012.

This translates into a banking system that’s doing very little banking.

In the latest 2012-2013 Global Competitiveness Report in fact, Libya ranks 140th out of 144 countries surveyed in terms of “financial sector development”. Cameroon – the team to beat to move to the next qualifying round of the 2014 World Cup – has already beaten Libya in terms of financial sector development. They’re 35 points ahead, ranking in 105th place.

The consequences of an underdeveloped financial system can be catastrophic, particularly for an economy like Libya’s, so dependent on hydrocarbon revenues. The evidence from around the world is clear, pointing to the private sector as the engine of sustainable economic growth and most importantly, job creation.

In order to thrive, the private sector requires financial intermediation: that is, deposits (people’s savings) converted into loans by banks, given to businesses, to invest in productive capacity and hiring.

Libya during the Gaddafi regime was never envisioned under this optic. The premise of a closed-off socialist regime is that the state is the provider of economic wealth, distributed by virtue of need (or more realistically: arbitrarily, by nepotism, loyalty or tribal allegiance).

Post-Revolution, the interim government hasn’t yet made a break from the past, continuing to be the main provider of jobs, subsidies and transfers. This is unsustainable for numerous reasons – primarily, because the source of the government’s wealth is oil and natural gas. These are finite resources (estimates give oil 77 years and natural gas 52 years for depletion at pre-Revolution extraction rates) and are subject to highly volatile prices.

Just last week, Oil Minister Al-Arusi warned that due to recent strikes, oil production had fallen to under 1m barrels per day – a “crisis” level in the government’s words. With the majority of Libyans currently dependent on public sector salaries and subsidies (derived from hydrocarbon revenues), Libya needs to quickly – very quickly – diversify away from the public sector – just to stay afloat. A key tool to make this diversification happen is the financial sector with the loans it can provide to small and mid-sized enterprises (SMEs).

Banking in Libya as a business, is actually fairing quite well. In addition to a significant asset base, the capital adequacy ratio of the banks stood at 17.3% in 2010 – to simplify it, this is the amount of money banks set aside to absorb big losses.

To understand this ratio in context: following the 2007 global financial crisis – an historic event -banks in the U.S., Europe and other economies are now legally required to raise their capital adequacy ratios to between 13 and 15% in the next few years and some banks will struggle to do so.

Libyan banks, in comparison, are already very well capitalized. The Revolution will have caused significant losses for the banks– particularly due to physical destruction of assets – but with the Central Bank’s swift actions to reverse the temporary liquidity crisis of the Revolution and only 21% non-performing loans recorded in 2012, the sector is again awash with cash.

So why aren’t the banks lending?

Because they don’t need to.

Following the lifting of the international embargo on Libya in 2003, the big focus in the economy turned to facilitating trade with the rest of the world. Riding the momentum, the banks began to issue letters of credit and guarantees for importers. This kind of financing activity, because of its structure and the reduced type of risk it poses to banks, isn’t included in balance sheet assets. Instead, it is termed “off-balance sheet assets” and at latest IMF estimates in 2010, these amounted to 84% of balance sheet assets (compared to only 12% in 2004). That’s 55bn in trade finance activities, compared to 8.8bn in private sector loans.

Lending to the private sector pales in comparisonto trade finance and banks are recording over 11% return on equity (a return comparable to that of big global banks) because of fee income generated from trade finance activities. Essentially,they don’t need to issue risky loans with slim interest margins to be profitable.To make matters worse, they also don’t depend on customer deposits for their capital base, instead receiving cash transfers from the government directly as a consequence of hydrocarbon windfalls (excess profits when global oil prices are high).

Because of regulation.

In another short-lived political victory for the outnumbered yet very vocal Islamist contingent in Libya, a law was hurriedly passed in January this year, under pressure from interest groups, outlawing non-Shariah compliant banking for companies and state entities after 2015. The law itself can be good for the Libyan economy (after all, it has been for other countries like Malaysia and Saudi Arabia) and certainly reflects the value system of the majority of Libyans. But President Morsi of Egypt isn’t the only Islamist with a lack of financial know-how.

The proponents of the law, who rushed to hail this as an Islamist victory, have seemingly not given thought to the practicality of its implementation. The 2015 deadline is unworkable, the banks are grossly unprepared and in the meantime, lending is at a standstill. Even willing lenders are uncertain as to what will happen to their loan portfolios once the interest ban is in place, so they prefer not to lend and instead adopt a “wait and see” approach towards the regulatory change.

In the meantime, this is hurting small and mid-sized enterprises and ordinary citizens who need loans to finance purchases. Many construction projects started before the Revolution are paralyzed, as an example, due to lack of financing.

Because they don’t know who to lend to.

Banks, by their very nature, are risk-taking institutions: by giving out a loan today, they are “betting” that the borrower – or at least the majority of borrowers – will be able to pay it back tomorrow. But commercial banks don’t ordinarily take gambles – they take calculated risks, based on available information (and complicated financial models). For example, a 30-something steadily employed homeowner presents less of a risk for a lender than a young high school dropout with “No Income, No Job and Assets” (referred to as a “NINJA” in the financial sector).

In order to assess the profile of potential borrowers and the risk they pose to the lender, banks need credit information. With this information they decide if they want to lend, how much to lend and at what cost. In Libya, there is a total lack of credit information services, for example an independent credit rating agency assigning credit scores based on borrowers’ past record of paying their debts (including their bills) on time. Without this information, Libyan banks can’t differentiate between “good” risks and “bad” risks and as a consequence, would rather not take the gamble.

Because: “The house belongs to he who lives in it” – Muammar Gaddafi, circa 1975

Infamous Law no. 4 issued by the Gaddafi regime in the late 1970s, banning rental properties (as a “bourgeois exploitation”) effectively caused a free-for-all raid on people’s houses by squatters. This means that 40 years down the line, property rights are widely disputed and disputable across the country. The first property squatters will have since re-sold the property and successive owners will have bought and re-sold the property again and again, legally, oftentimes without knowledge of the expropriation of the past.

Following the Revolution, this is a serious concern for the banks, as many loans are secured by property as the collateral. When the rightful owner of the collateral is under dispute and loan repayments don’t come through, the bank may have no way to cover its losses. This is a unique issue for Libyan banks and again, a gamble not worth taking.

Because of lack of legal recourse.

When a borrower doesn’t repay a loan on time and in full, the lender – the bank – will seek legal recourse from the courts to seize the borrower’s assets to cover its losses. The court system in Libya lacks transparency, is ineffective, bureaucratic and slow to dispense justice. This makes lending in Libya (and many other enterprises as a matter of fact) an extremely riskybusiness and hardly worthwhile.

Because they don’t know how.

With a lack of financial sector development comes a lack of human capacity. Banking, finance, economics and related fields of study are understandably not top choices for graduates in Libya at the present time. The result is that Libyan banks lack the know-how to determine their risk appetite, structure loan products, attract the right types of clients and manage the ongoing risks in the portfolio.

So what to do about Libya’s financial sector?

First of all, policymakers, as well as the general voting public, must recognize the financial sector for its strategic importance and for the critical role it can play in diversifying the Libyan economy away from hydrocarbon dependency. Hydrocarbons are finite, volatile, prone to security threats and capital intensive, which means they can’t contribute significantly to employment growth in the coming years.

While the banks remain in government hands, it is even more essential that they be seen as tools of macroeconomic policy implementation – first and foremost, to boost youth employment. The government budget has no capacity to continue hiring or providing subsidies indefinitely, so private sector growth is vital for Libya’s economic wellbeing.

From the low 2010 base of LYD 8.8bn in private sector loans (the latest available data), if the banks were to double this figure to 17.6bn over a five year period, that would amount to theequivalent of the entire annual public sector wage bill. To illustrate the impact this can have: if each small business is given, for instance, an average loan of LYD 100,000 to buy machinery and hire employees, that’s over 80,000 new business loans. And that would still only be a mere 27% of bank assets tied up in private sector loans.

The spokesperson for the Minister of Labor and Rehabilitation, Rabia Ammar, noted in March this year, that unemployment in Libya stands at 15% or 160,000 people unemployed. The number is widely disputed and is likely closer to 30%, particularly for youth unemployment. Nonetheless, in the illustration, if each small business issued a loan hires an average of just two Libyan employees that would amount to 160,000 new jobs over a five-year period.

Before getting too excited about the numbers though, the reality is that if banks do begin to issue new loans they are likely to focus on larger, more stable, higher-quality business customers, rather than start-ups with no track record -simply because they pose less of a risk. These larger businesses are likely to be more capital intensive andmay focus on hiring cheaper expat workers, so the benefits to small businesses and Libyan employment may take time to accrue. The issue also remains as to how many potential Libyan entrepreneurs exist out there who would apply for a loan and how many have the skills to survive past start-up.

However, the premise remains that relatively small increases in loans, targeted towards small and mid-sized businesses, coupled perhaps with a labor nationalization program, training and other initiatives to support SMEs, can have magnitudes of impact on domestic employment growth, particularly in the medium term and with certainty over the long term.

Bold moves today

From a policy perspective, the government can take two swift actions in the short term to support the financial sector. The first is to extend the deadline for implementation of the Shariah compliance law until 2018 – past the next election cycle. This can give the sector enough time to put in place the infrastructure and training required to comply with the law and shield these preparation efforts from being used as an expedient political pawn around election time.

Libya’sCentral Bank Governor Saddek AlKaber has already signed, in May this year, an agreement with Malaysia’s International Centre for Education in Islamic Finance to provide bank staff with training. But large-scale training takes time to yield the desired effects.

It is also worth noting that in discussions with the IMF held in February and March this year, the Central Bank revealed that despite the law, it was more favorable to running a dual banking system, with both conventional and Shariah-compliant banking working side by side. In the current security environment, this probably isn’t something they will want to shout from the rooftops, but for the rest of us, does reveal a welcome and unique pragmatism – and do we dare say wisdom – at the top levels of Libya’s administration.

Secondly, the government should grant amnesty to interest-based loan portfolios issued in advance of the regulatory change, allowing banks to convert interest-based loans to Shariah-compliant structures on a best-efforts basis once the deadline hits. Given adequate time to prepare, banks should be able to write loan contracts with clauses anticipating the regulatory change and explain to customers how this will impact their repayment schedules. The deadline extension and amnesty can be the single most effective measurestoday to remove uncertainty and help the willing banks issue loans.

Even bolder moves tomorrow

In the medium term, policymakers must improve the governance of the banks by introducing privatizations, decoupling the financial sector from the Central Bank and introducing modern management practices and competition.

Decoupling the banks from the state means they will have to depend on customer deposits (currently amounting to only LYD 20bn) and loans for their capital base and profitability, rather than cash transfers from the government.Privatizations can in a first phase exclude rural credit institutions that provide subsidized credit facilities to sectors like agriculture that need more support.

Just before the Revolution, the government had begun a round of bids for two banking licenses to be issued to foreign players. The result of the bid process was that only one license was issued to Italy’s UniCredit just before the Revolution.

This round should be re-opened and the number of licenses available increased. Banks run on international management practices will seek to hire more qualified employees, creating opportunities for private sector-led training and development programs in banking, financial analysis, economics, statistics and risk management for young Libyan graduates. Here is a concrete job creation opportunity – and these are white-collar, well-paid jobs.

A new, independent, financial services’ authority should then be established to provide oversight and ensure the soundness of the sector. Importantly, the financial services authority should monitor bank capital adequacy ratios, to make sure they are taking appropriate risks and remain solvent. A financial services authority is also beneficial to safeguard consumers from predatory practices in both banking and insurance.

Simultaneously, an independent credit rating agency should be established. In a way, the foundations for it are there. To counteract abuses in the payment system for the injured of the Revolution, the Zeidan government has established a system of unique National ID numbers for each citizen. This unique identifier can also be used to identify potential borrowers – much like a Social Security or National Insurance number in the U.S., Canada and the U.K. Potential borrowers should then be encouraged to self-select into the credit rating system at first and disclose information as a pre-requisite to obtaining a loan.

The richness and quality of data needed to assess credit risk effectively takes years to build and needs both a powerful and connected IT infrastructure and skilled professionals to administer and analyze its outputs. But it must start somewhere. Coupled with the purring sounds the government has made towards e-government initiatives over the past year, the opportunity to add concrete value – in terms of data – is there.

The housing and property rights issue must also be tackled, in order to release properties and make them available to be posted as collateral for loans. After all, property values in Libya are sky-high,due to a shortage in housingand regulation stipulating that only Libyan citizens can own land. The equity value in these properties can make for high-quality collateral for loans.

However, the legal and practical implications of resolving property rights disputes are enormous: for starters, if properties are returned to their original owners, who will compensate existing owners who bought them legally without knowledge of the expropriation that took place decades ago? And where would these families then live? And if properties are not returned to their original owners, who will compensate them for the loss they incurred due to damaging government policy of the past? Is the government budget able to sustain large-scale compensation programs?

A structured legal framework and process is required to resolve the issue (it is a politically sensitive and potentially expensive one to tackle) but a practical first step may be to issue a deadline for citizens to file property rights complaints with the courts. Past the deadline and any required extensions to it, properties against which no complaints have been filed are free to be posted as collateral, removing the uncertainty faced by banks as to who the owner they can seek recourse against is. Removing uncertainty decreases risk and encourages lending.

The courts will then have the time to investigate and hear the property rights complaints raised and the government to devise a palatable solution. This will take years and requires a government – unlike PM Zeidan’s – benefiting from public confidence. Don’t hold your breath in this space at least as far as the current government is concerned. Nonetheless, in the short term, local city councils also have a critical role to play, by enforcing tight controls at their respective Land Registry departments – notoriously un-transparent environments, subject to much corruption and abuse.

Finally, the most significant relief the government can give the financial sector in Libya is to decouple it from the country’s ineffective judicial system. The Dubai International Finance Center (DIFC), a regional center of excellence for banking, runs its own legal framework and court system, independent from the Government of Dubai or the UAE – essentially a legal system within a legal system. The legal regime in the DIFC is modeled on international standards and the Common Law system, providing mechanisms for independent (and fast tracked) arbitration and insolvency proceedings. A similar financial free trade zone and international regulatory framework are sorely needed in Libya.

The financial sector simply can’t wait.

The views expressed in this article are the author's own and do not necessarily reflect Libyan Express's editorial policy.

International Manager at one of the world's largest financial institutions, with experience working in four countries to date in a variety of roles. In my spare time, I'm a commentator on Libyan economic and financial affairs.